Maris Lauri and Annika Paabut, Swedbank, Talinn.

Key Concepts: Economic Growth | Structural Change | Inflation |

After seven quarters of decline, the Estonian economy began to grow again in the fourth quarter of 2009, as revised statistics show. The recovery is based on exports,
which are benefiting from revived global trade and the regained competitiveness of local producers. Consumption has remained weak due to declining incomes; however, it has
shown a slight pickup lately, as consumers’ moods have turned positive. After an intensive period of destocking, inventories are now growing again.

Estonia has received an invitation to become the 17th member of the European Economic Monetary Union (EMU), as a reflection of fulfilling the Maastricht criteria,
accomplished during the height of the global financial crisis. The country also signed a membership agreement with the OECD in early June, and, after final ratification in
Parliament, Estonia will become the 34th full member of the organisation.

We have revised our outlook based on the better growth and worse employment pattern reported so far in 2010, as well as the changed global environment. We expect the
Estonian economy to grow by 2.2% in 2010, and by 4.5% in 2011 and 2012. We have also raised our inflation expectations, as global price hikes have caused prices in Estonia to
grow more than we expected in the spring. Due to very slow job creation in the first half of 2010 and a high activity rate, we foresee that the average unemployment rate will
remain only marginally below 18% this year. This will keep household consumption low and the savings level high, despite growing optimism.

Of the more significant risks for our scenario, the biggest is related to the global economic development. As the Estonian economy is very open, external conditions,
whether improving or deteriorating, will affect the economy through demand and prices.

Looking at the experiences of previous countries, euro adoption has had strong positive effects on their economies. Nevertheless, taking into account the current uncertain
global economic situation and outlook, we have not included a significant positive impact on Estonia’s economy stemming from the adoption of the euro. Hence, it is possible
that foreign investments and production growth will turn out to be higher than we currently forecast. This, in turn, would have a positive effect on the labour market,
consumption, and budget revenues.

Regarding medium- and long-term risks that might affect economic developments in 2012, companies’ investment policies and labour outflows remain among the main risks that
could affect the current growth outlook, either positively or negatively.

Chart 1: Contributions to GDP Growth

Economic Growth Based on Exports & Investments

In 2010, we foresee the Estonian economy growing by 2.2%, supported mostly by exports. However, a positive effect on growth will also come from stock building. After
approximately 1% growth this year, we expect domestic demand to strengthen by 4% in 2011 and close to 5% in 2012. Investments will be the most dynamic component of domestic
demand in the forecast period as both public and private investments will grow. While household investments in new housing will grow modestly, as the real estate sector will
still be feeling the consequences of the crisis, companies will increasingly invest in machinery and equipment.

Household consumption will decline this year by 3%, but grow by 3.5% in the following two years. Government consumption will decline in 2010, but in 2011-2012 slight growth
is expected, as the public sector will be able to expand spending.

Export growth will slow next year due not only to weaker growth in Estonia’s main export markets, but also because capacities will be fully employed in the rapidly growing
export sectors as early as late 2010 and early 2011. The investment process will require time, and access to financing will remain somewhat limited at this early period of the
economic recovery.

Chart 2: Swedbank's GDP Forecast for Estonia

Alongside exports, imports have been gathering speed as a substantial share of the inputs of Estonian export products are imported. Buoyed by the growing optimism,
companies have started to invest and rebuild inventories – hence imports will begin to out pace exports before the end of 2010.

Strong Export Growth to Recede in 2011 as Global Growth Slows

The recovery of Estonian economic growth is strongly dependent on external demand. As most of Estonia’s main trading partners have recovered from the crisis faster than
expected, Estonian exports have grown more than we forecast in April. This allows us to increase our expectations regarding export growth in 2010. However, we expect growth to
slow substantially in 2011, mostly due to a slowdown of growth in European markets but partly due to capacity constraints on Estonian companies. Supported by the reviving
global economy, we foresee Estonian export growth to continue in 2012.

Cost cutting has increased the cost competitiveness of producers of low-priced products and services, but we foresee that this current cost advantage will diminish faster
than many producers and investors expect. Although Estonia will be the country with the lowest price and cost levels in the euro zone, there will be countries with lower cost
levels in the EU and Estonia’s neighbourhood. Energy prices are also on the rise, particularly those of natural gas and electricity. The main reason for these strong price
hikes is the isolated market but for electricity the opening of the market, i.e., deregulation, we believe could, in the case of Estonia, be important as well. Labour costs
will also increase, as labour supply diminishes due to demographic developments, labour outflow, and structural problems.

Consequently, cheap production cannot survive in Estonia for long. While, this year – and maybe in the first half of 2011 – exports will grow, due to expansion of cheap
production, we foresee another structural shift coming as costs inflate and force low-cost producers to stop production or shift to higher-priced products. We also see that
companies now rapidly expanding their production will soon face capacity constraints – similar to the ones seen during the crisis, when too few investments were made – and
existing capacities will soon be fully exhausted. These developments, together with slowed growth in Estonia’s main export markets, will affect Estonian production and export
growth rates, which will slow substantially in 2011. However, we expect a recovery of growth rates at the end of 2011, when external demand is expected to pick up and some of
the capacity constraints are alleviated through growing investments.

Chart 3: Exports of Goods and Services

Import growth was stronger than we expected in spring. Faster-growing exports also need more imported inputs (energy, raw materials, and details). Imports will also benefit
from growing company investments, which require more machinery and equipment. Additionally, companies are recovering their exhausted inventories – the process has been much
more intensive this year than we had previously foreseen. Growing consumption will increase demand for imported goods in 2011-2012.

An important reason why we are less optimistic regarding exports and imports is related to services. While exports of Estonian services performed very well during the
crisis, this seems to have changed in the second quarter of 2010. Hence, we have lowered our expectations regarding growth of services exports and increased our expectations
for services imports. Although services are partly substitutable, there are higher barriers in place than for the goods market. In some cases the number of service providers
might be very low or the situation may be very close to monopolistic.

We still expect Estonia’s current and capital account to be in surplus throughout the forecast period, but we foresee it diminishing faster than we thought in spring.
Besides a smaller trade and services surplus, we expect the income account deficit to be bigger as company profits are growing much faster than anticipated. We also foresee
workers’ remittances as being somewhat bigger, as more people are moving to work abroad, and interest payments to be smaller as interest rates will remain low for a longer
period than previously expected.

Infrastructure and Technology Investments to Grow

We expect investments to grow by approximately 11.5% this year as stocks are growing after a sharp correction in 2009. Gross fixed capital formation will continue to
decline this year, although annual growth is expected to resume in the third quarter. It will then expand more than 11% next year, with growth then slowing to 10% in 2012.

This increase in capital formation should be in line with growth in public sector investments, which, in turn should be supported by EU financing, while companies are
increasing their investments in technology. Public investments will increase as big infrastructure investments are on the rise. Companies are also being forced to increase
investments in machinery and equipment to tackle the issue of growing costs and maintain competitiveness. Although these types of investment have been growing since the
beginning of the year, we expect growth to accelerate in the second half of 2010.

Construction of houses will remain weak throughout the forecast period, although slight growth will be seen next year. Public sector investments in this area will remain
low due to budget constraints, and households will not be eager to buy new real estate. We expect some development projects to start next winter or spring, but we foresee the
overall activity in the real estate development to remain subdued for some time owing to weak demand.

Public investments will mostly be financed by different EU funds. Stronger companies will rely on their own funds, but we foresee borrowing from abroad increasing as well.
Borrowing from parent companies will be the most widespread, but we expect bigger companies to borrow directly from abroad. Local lending will remain relatively weak, and loan
portfolios of local banks will continue to decline in 2010 and into (at least) the first half of 2011, due to tightened credit conditions and the deleveraging process.

Wages Growing Despite High Unemployment

The average unemployment rate in 2010 – approximately 17.8% – will be higher than forecast in spring; however, we expect it to decline to 12.5% by 2012. We have increased
our unemployment expectations mostly for two reasons. First, the activity rate of the working-age population has remained unusually high – and we do not foresee it declining
throughout the forecast period. Second, job creation in the first half of 2010 was not as strong as expected.

Chart 4: Labour Market Indicators

Chart 5: Major Price Indices

The official job-seekers’ rate has been falling since spring, suggesting that more people are looking for jobs themselves, are employed in the hidden economy or are abroad.
As surveys show, regular unofficial wage payments have not grown much during the crisis in Estonia; hence, we are of the opinion that short-time and temporary unofficial jobs
are on the rise. Working abroad, including through local companies, has grown in 2010, as shown by the growth of workers’ remittances received and we expect this to intensify
in 2011-2012.

However, slow job creation is being offset by growing productivity and an increasing number of working hours. We estimate that, at least this winter, companies will have to
start to employ more workers as there are limits to expanding production by increasing working hours.

We expect the average monthly gross real wage to decline by 1% this year and grow by 2% in 2011 and 2.5% in 2012. This upward revision is the result of a slightly better
than expected outcome in the second quarter of 2010 and stronger productivity.

However, wage growth may turn out to be higher than we currently assume. The labour shortages in specific areas may lead to stronger wage growth in these sectors, which
could then spread into other sectors. If this happens, the average wage growth will accelerate either in the second half of 2011 or in 2012.

Inflation to Pick Up in Winter Before Receding

We have upgraded our consumer price inflation expectations for this year and the next due to stronger-than-expected growth last spring. We expect prices to rise by 2.6% in
2010, followed by 3% and 3.5% in 2011 and 2012, respectively. Still, annual rates during the upcoming winter could reach 4% or even more due to the low base, increase in
energy prices, and recovering demand.

The underlying price inflation is the result of the convergence process, which will most likely intensify after Estonia enters the EMU in Janurary 2011. First, the euro
zone entrance coincides with the economic recovery, which itself will generate price pressures. Second, the euro makes it easier to compare prices in Estonia with those in
other EU countries, particularly Finland. Companies may find excuses to increase prices (e.g., for some food products), although consumers will find also reasons for complaint
in several other cases (e.g., industrial goods). We expect external pressure on Estonia’s price level to be modest in the future; nevertheless, it was strong this spring and
summer, and this is one reason for our inflation forecast upgrade. Negative surprises are also possible, if global prices – particularly for energy and food – grow faster than
currently projected.

Administrative price growth in coming years will be smaller than in 2009-2010: currently only an increase in tobacco excises is planned for 2011 and 2012. Other regulated
prices have also come under much tighter scrutiny than before following changes to the regulatory process.

Chart 6: Confidence Indices

Two factors are at work to lower inflation pressures in 2010 and in the first half of 2011. First, weak consumption demand makes it difficult to increase prices
substantially. However, due to low competition in some sectors, owing to the limited number of companies present, this effect will not be very strong. Second, the price
controls related to euro adoption, which have captured much media attention, might at least postpone some of the price increases to the later half of 2011. It is normal to
expect that, due to price convergence, the inflation rate in Estonia will be higher than in the richer euro zone countries for several years. However, this difference should
not be too big, as faster inflation would undermine households’ spending and weaken companies’ competitiveness.

Households to Keep Their Spending Low

Household consumption will decline by 3% this year, but grow by 3.5% in 2011-2012. The major factors keeping consumption subdued are high unemployment, low incomes, and
growing savings. As inflation rises – particularly for primary necessity goods and services (such as food and housing) – price growth will become a limiting factor for
spending growth in late 2010 and 2011 as it will take place at a time when incomes are not yet growing.

While consumer confidence has already been improving for more than a year, being above the long-term average for several months, this improvement has not brought with it a
substantial recovery of consumption. The purchases of most goods and services are still declining compared to last year as households try to adjust their spending and increase
savings. However, a slight shift towards higher spending levels has taken place recently, as our analysis shows. Yet we are of the opinion that this recovery will remain
subdued, at least until the middle of 2011.

Despite gradually rising incomes, the household savings rate will remain high. One reason is the deleveraging process, and another is the shift in household behaviour that
took place in 2008. We are of the opinion that this behaviour will not change in our forecast period. Weak household demand will suppress local small companies and employment,
while growing prices and the relatively high price level of certain goods (e.g., clothing and electronics) will encourage shopping tourism, thus worsening the situation for
local companies.

Euro Adoption to Have a Modest Short-Term Impact

Estonia will become the 17th member of the EMU at the beginning of 2011. The preparation period will bring costs to companies; however, it will also bring beneficial
effects to some companies through increased demand (e.g., IT services). Also, the preparation period will most likely slow possible price increases as price controls are
being put in place which, it is hoped, will work effectively to combat excessive inflation. These controls are getting wide media coverage and are the biggest public concern
regarding euro adoption.

The pre-introduction period also includes the process of aligning Estonian monetary regulations with those of the euro zone. Primarily, this means that the reserve
requirement will be lowered from 15% to 2%. The first cut took place on September 1 (to 11%), the next is scheduled for November 1 (to 7%), with the final cut taking place on
January 1, 2011. The central bank estimates that approximately EEK40 billion (EUR2.6 billion) of additional liquidity could be injected into the economy as a result. However,
it is highly probable that banks will use a portion of those sums to redeem loans and to keep additional reserves. Hence, we do not expect any substantial effect of this
monetary easing on banks’ lending policies.

Euro adoption will lower risks and bring a more stable economic environment. We therefore expect increased capital inflows into the economy; however, we are not projecting
these to be at the levels seen in Slovenia or Slovakia, as the current global economic situation is not very favourable for investments. Yet, a better outcome is possible.
This would, in turn, increase not only production, jobs, incomes, and consumption, but also prices and wages more than expected in our current scenario; bigger tax revenues
would allow the government to reach their balanced budget target earlier than currently projected.

Chart 7: General Government Finances

Budget to Remain in Deficit

The likelihood of the government’s policy changing is low, and we are of the opinion that the government will succeed with its ambition to reach a balanced budget by 2014.
We foresee that the public sector budget deficit will gradually decline throughout the forecast period. This development, however, means that the government will have to
continue with the consolidation of the public services, as commitments taken in spring 2009 – at a time of heavy cuts – will significantly increase compulsory spending from
2011 onward. The conservative budget planning, in which lower revenue expectations – rather than average or positive ones – are taken as the base, makes it possible to
overshoot the budget revenue plans not only in 2010, but most likely in 2011 and 2012 as well (if global economic developments remain in line with expectations).

Significant tax changes are unlikely to take place during the forecast period. The excise on tobacco products is scheduled to be raised at the beginning of 2011 and 2012.
It is possible that some other changes in the tax system will be enacted in 2012, but this will depend on the coalition that takes office after the general elections in March
2011. As of now, the economic recovery is giving the current government coalition a good chance of continuing in office after the elections. And, should the current coalition
remain in power, the shift from direct taxes toward indirect taxation will continue. A lowering of the unemployment insurance payment rate from the current 4.3% is the most
likely change to take place, but this has yet to be scheduled.

The government’s structural policies will include steps aimed at improving the business environment, encompassing mostly public investments in infrastructure and
particularly the energy sector and transportation. The reform of general education started in September, and we are of the opinion that the government should now substantially
intensify its work on other important structural issues related to education. For example, decisive steps to re-educate and retrain the unemployed are required to prevent
unemployment becoming more and more long term.